Chapter 22

Microeconomics Unit III: The Theory of the Firm

Monopoly

While a competitive firm is a price taker, a monopoly firm is a price maker.

A firm is considered a monopoly if . . .it is the sole seller of its product.its product does not have close substitutes.

Monopolies

The fundamental cause of monopoly is barriers to entry.

Why Monopolies Arise…

Barriers to entry have three sources:Ownership of a key resource.The government gives a single firm the

exclusive right to produce some good.Costs of production make a single producer

more efficient than a large number of producers.

Why Monopolies Arise…

Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.

Monopoly Resources

Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets.Patents and copyrights

Government-Created Monopolies

An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.

A natural monopoly arises when there are economies of scale over the relevant range of output.

Natural Monopolies

Monopoly versus CompetitionCompetitive Firm

Is one of many producersFaces a horizontal demand curveIs a price takerSells as much or as little at same price

MonopolyIs the sole producerFaces a downward-sloping demand curveIs a price makerReduces price to increase sales

HOW MONOPOLIES MAKE PRODUCTION AND PRICING DECISIONS

Total RevenueTR = P x Q

Average RevenueAR = TR/Q = P

Marginal RevenueMR = ΔTR/ΔQ

A Monopoly’s Revenue

A Monopoly’s Marginal RevenueA monopolist’s marginal revenue is always less

than the price of its good.The demand curve is downward sloping.When a monopoly drops the price to sell one more

unit, the revenue received from previously sold units also decreases.

When a monopoly increases the amount it sells, it has two effects on total revenue (P x Q).The quantity or output effect – more output is sold,

so Q is higher.The price effect – price falls, so P is lower.

A Monopoly’s Revenue

Visual 3.10http://apeconomics.ncee.net

Price and Marginal Revenue for aMonopolist

A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.

It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Profit Maximization

Comparing Monopoly and CompetitionFor a competitive firm, price equals marginal

cost.P = MR = MC

For a monopoly firm, price exceeds marginal cost.P > MR = MC

Profit Maximization

Profit equals total revenue minus total costs.Profit = TR-TCProfit = (TR/Q – TC/Q) × QProfit = (P-ATC) × Q

A Monopoly’s Profit

Monopolist’s ProfitThe monopolist will receive economic profits

as long as price is greater than average total cost.

Step 1: Determine profit-maximizing output where MR=MC

Step 2: Determine profit-maximizing price by extending a vertical line up from output determined in step 1 to the monopolist’s demand curve

Step 3: Determine economic profit by using one of two methods (wait for it… on the next slide…)

How to graphically determine profit-maximizing output, profit-maximizing price, and economic profit for monopolist

Method 1Find out profit per unit by subtracting ATC of

profit-maximizing output from profit-maximizing price.

Then, multiply the difference by the profit-maximizing output to get the economic profit.

Method 2Find TC by multiplying ATC of the profit-

maximizing output by that output.Find TR by multiplying profit-maximizing

output by profit-maximizing price.Then, TC-TR = economic profit.

How to graphically determine economic profit for monopolist

In contrast to a competitive firm, the monopoly charges a price above the marginal cost.

From the standpoint of consumers, this high price makes monopoly undesirable.

However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable.

THE WELFARE COST OF MONOPOLY

A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax

Because a monopoly sets its price above marginal cost, it places a wedge between the consumer's willingness to pay and the producer’s cost.This wedge causes the quantity sold to fall

short of the societal optimum.

The Deadweight Loss

The Inefficiency of MonopolyThe monopolist produces less than the socially

efficient quantity of output.The deadweight loss caused by a monopoly is

similar to the deadweight loss caused by a tax.

The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit.

The Deadweight Loss

Deadweight Loss Caused by Tax

The Deadweight LossDeadweight Loss

Caused by Monopoly

Regulating MonopoliesMonday, 22 September, and Tuesday, 23 September

Government responds to the problem of monopoly in one of four ways.Making monopolized industries more

competitive.Regulating the behavior of monopolies.Turning some private monopolies into public

enterprises.Doing nothing at all.

Public Policy Toward Monopolies

Antitrust laws are a collection of statutes aimed at curbing monopoly power.

Antitrust laws give government various ways to promote competition.They allow government to prevent mergers.They allow government to break up companies.They prevent companies from performing

activities that make markets less competitive.

Increasing Competition with Antitrust Laws

Two Important Antitrust LawsSherman Antitrust Act (1890)

Reduced the market power of the large and powerful “trusts” of that time period.

Clayton Act (1914)Strengthened the government’s powers and

authorized private lawsuits.

Increasing Competition with Antitrust Laws

Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.

PRICE DISCRIMINATION

Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power.

Perfect Price DiscriminationPerfect price discrimination refers to the

situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.

PRICE DISCRIMINATION

Two important effects of price discrimination:It can increase the monopolist’s profits.It can reduce deadweight loss.

PRICE DISCRIMINATION

Examples of Price DiscriminationMovie ticketsAirline pricesDiscount couponsFinancial aidQuantity discounts

PRICE DISCRIMINATION

What is a natural monopoly?One in which the market demand curve cuts the

long-run ATC curve where ATC is still decliningWhile it may seem the natural monopoly’s

lower unit cost will enable it to charge a lower price than if the industry were more competitive, but this is not necessarily so…

Instead, natural monopolists may set price far above ATC and get substantial economic profits

Means big profits for firm and higher prices for consumers

Natural Monopoly

Government may regulate the prices that the natural monopoly charges.The allocation of resources will be efficient if

price is set to equal marginal cost.

Regulation

Marginal-Cost Pricing for a Natural Monopoly

In practice, regulators will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing.

Regulation

Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself (e.g. in the United States, the government runs the Postal Service).

Public Ownership

Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies.

Doing Nothing

How prevalent are the problems of monopolies?Monopolies are common.Most firms have some control over their prices

because of differentiated products.Firms with substantial monopoly power are

rare. Few goods are truly unique.

CONCLUSION: THE PREVALENCE OFMONOPOLY